Canadian Banks - U.S. Investors Should Look Out For This Threat

Summary

The Canadian banks are a beacon of stability thanks to their long term growth targets and more conservative approach to finance.

The Canadian economy and Canadian dollar are suffering thanks to the collapse in the commodity market. The recent recession may not be completely behind Canada as some initially suggested.

Some banks are better positioned with a higher exposure to the U.S. market.

International investors in Canadian banks can expect a bumpy road ahead until the Loonie stabilizes.

The Canadian banks are old legendary institutions that have stood the test of time. They remained a beacon of stability during the financial crisis and came our relatively unscathed. This is because, the Canadian institutions have always remained focused on long term growth and always been a bit conservative than their U.S. counterparts. It is for this reason, that the Canadian banks almost always find a spot or two featured in the list of safest banks in the world.

The Canadian banks can be classified into two tiers - the national/international banks and the regional banks. The lion's share goes to the Big Five - Royal Bank of Canada (NYSE:RY), Toronto-Dominion Bank (NYSE:TD), Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO) and Canadian Imperial Bank of Commerce (NYSE:CM).

The banks are known for their reliable dividend income stream. While the banks suffered during the financial crisis of 2008 just like other banks, the Canadian banks paused raising their dividends but have started raising them again. The oldest dividend payer in Canadian corporation history (not just in the financial sector) is Bank of Montreal, which has paid dividends since 1829. A close second comes Bank of Nova Scotia which started paying dividends in 1832. The other banks are just as impressive - Royal Bank started paying dividends in 1870, TD started paying in 1857 and CM started paying in 1868. These financial institutions have been through a lot including two world wars, numerous financial crises, depression etc. So, they are ideal candidates for long term investors.

Market Conditions

It is hardly a secret that Canada is suffering. The Canadian economy is heavily reliant on resources and with the oil and commodity market suffering badly, Canada has been in a recession since early to mid 2015. Some economists argued that it was technically not a recession since the job losses were a bit more subdued and did not go hand-in-hand with the contraction of two consecutive quarters. While there were some economists who concluded that Canada was officially out of a recession by the end of year, there have been doubts whether that's really the case.

In addition to the ongoing or recently concluded recession, there are other threats to the economy too. Most notably, is the housing bubble where economists and central bankers (including our own Bank of Canada governor - Stephen Poloz) have confirmed that the housing market is overinflated and probably in a bubble. But the central bank is caught between a rock and a hard place - and has had to cut interest rates twice (by 25 basis points each time) in 2015 in order to stimulate the economy. In response, the banks decided to cut the prime rate by less than the 25 basis points each time.

(Source: Created by author. Data from Bank of Canada)

Looking at the data from the past 10 years, the overnight interest rate and prime rate have moved together as the economy waxed and waned. The chart shows that from Jan 2005 to Nov 2008, the difference in interest rate and prime rate was 175 basis points. Starting Dec 2008, that was upped to 200 basis points. The banks have profited and returned to record profits since then. Now, the banks have started taking a bigger cut with the spread expanding to 210 basis points. This might get even bigger as Bank of Canada is expected to cut rates again this year - and probably as early as the next announcement on Jan 20, 2016.

Currency Risks

The big point that I want to make in this article is the currency risk - both from the companies' earnings results and from the dividend returns investors can expect. But before I present the meat of the argument, a quick update on what the Canadian dollar (called the Loonie) is doing.

The Canadian dollar, as with the Canadian economy, is closely tied to the resources and commodities market. Some have even suggested that it is a petrodollar. When commodity prices were high right after the financial crisis, the Loonie was on par with the USD and even getting to 1.05 USD per 1 CAD. But now that the commodity markets have collapsed, the Loonie has suffered. The following chart shows how the rise of USD has destroyed the value of Loonie.

Stephen Poloz, Bank of Canada's governor, recently has made comments cheerleading the decline in the Loonie. "It is not a coincidence that the Canadian dollar is about where it was back in 2003 and 2004," Poloz said. "Oil prices are also about where they were back then. The depreciation of our currency is a natural part of the process." Following the speech, he bristled at the suggestion during a media Q&A that he was 'cheerleading' the loonie's decline. "It's not something to cheer for," he said. "We would of course prefer oil prices to be a little higher."

With the drop in Loonie's value, we can expect a few changes in each company's earnings results and the expected rate of returns.

Canadian banks with a higher U.S. exposure can expect an extra tailwind in their financials, as the banks report quarterly results converted into CAD. Taking this into account, of the five banks - Royal Bank of Canada (US portion will increase more going forward after the City National acquisition), Toronto-Dominion Bank, and Bank of Montreal have an extra edge.

Following image was created by me by gathering the data of geographical revenue diversification of each bank updated after the 2015 annual reports were released. The image shows what part of the revenue comes from each region for the five banks.

(Source: Created by author. Data from each 2015 annual reports from each bank)

A big part of the returns for folks investing in banks are the dividends. Remember the dividends are declared and issued in CAD. So, for Canadian investors, this is fine. Banks have been raising dividends again since the financial crisis and will raise them again this year. But for investors who buy the U.S.-listed shares of these companies (or even international investors who hold TSX-listed shares, but eventually depend on converting the dividends to your local currency) results in lower dividends when converted to USD (or local currency), thanks to the collapsing Loonie.

Putting it all together

The Canadian economy is facing plenty of headwinds thanks to the collapse of the oil and commodity markets, recent recession and the possibility of a housing bubble bursting. As a result, the Canadian dollar (Loonie) has suffered losing approximately 50% of its value since its peak in the post financial crisis years. The Canadian banks have been safe investments and over the long run will still be great for investors - but international investors should expect a bumpy road ahead thanks to the falling Loonie. Banks with a higher exposure to the U.S. market (RY, TD and BMO) will benefit from the strong USD. In addition, dividend returns may be a bit depressed for international investors until the Loonie stabilizes.

Full Disclosure: Long BNS, TD. My full list of holdings is available here.